Sunday, October 12, 2008
Big and bold, but will it cure the patient?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


What can one say after a week like that? Dramatic market moves can be cathartic or a signal of grim times ahead. Dramatic policy moves can either be desperation or a well-judged response to prevent gloom turning to disaster. G7 promises of drastic action may be praised or dismissed as a damp squib.

If I say only time will tell, many will see it as a cop-out, but it is also the only sensible thing to say. So volatile and destructive are markets that apparent calm gives way to frenzy at the drop of a hat. Once-in-a-lifetime events happen almost daily; the unthinkable becomes routine. Huge stock-market falls become almost matter-of-fact.

The government announced on Wednesday what would have seemed unthinkable a month earlier a mass bailout of the UK banking system, including at least 50 billion of taxpayer-funded capital injections and almost limitless provision of liquidity and official banking guarantees.

The Bank of England, caught since April between worries about inflation and the credit crunch one member of its monetary policy committee voted for a rate hike in August was suddenly taking part in a co-ordinated half-point rate cut with the Federal Reserve, the European Central Bank and other central banks. Even after the September 11 attacks on America, central banks did not cut rates on the same day. The ECB, making hawkish noises until a few days ago, underwent an even bigger Damascene conversion.

The stability and restructuring plan (Sarp), as Gordon Brown calls it the name has not caught on but is better than comprehensive restructuring action plan is bold and clever.

It ticks all the boxes of recapitalising the banks, providing them with another huge slug of liquidity at least 200 billion under the special liquidity scheme and up to 250 billion of government guarantees against new debt issuance by the banks. It hangs together as a package; the banks do not get the guarantees unless they agree to the recapitalisation.

It is a reminder that the policy machine can be very good indeed. The British plan will be a template for other countries and undoes some of the reputational damage suffered by the Treasury, Bank and Financial Services Authority over the past year.

Real wars are under the spotlight of 24-hour TV and so are economic wars. Policymakers, like generals, will have often thought about putting a boot through the screen in recent days. History is being made. So where does it leave us?

One quick way of assessing the economic impact of the past three to four weeks is to look at the International Monetary Fund, holding its annual meeting in Washington this weekend. On September 18 John Lipsky, its deputy managing director, gave a speech looking forward to the IMF's new forecasts.

Global growth, he said, would be 4% in 2008 and somewhat below 4% in 2009. At that time the IMF's last assessment for Britain was 1.4% growth this year, 1.1% next.

Now the air is thick with the sound of economists chopping forecasts. Global growth this year is expected to be 3.9%. "Somewhat below 4%" next year has turned into 3%. Britain is seen as growing by 1% this year and shrinking 0.1% next.

The IMF's best guess is that the crisis of the past few weeks has lopped a percentage point off next year's economic growth and, as it admits, there are considerable "downside risks" to its new projections.

Hank Paulson's decision to let Lehman Brothers fail the first domino and a move attacked by French finance minister Christine Lagarde last week as "horrendous" will cost the world about $650 billion (378 billion) of lost output next year. Britain loses about 15 billion of GDP.

The shape of the IMF forecast is as it was: not much growth in advanced economies but a lot in the emerging world. All, however, are expected to be less strong than previously thought, so advanced economies as a group will grow 0.5% next year, emerging economies by 6.1%, boosted by China with 9.3% growth and India with 6.9%.

To put this in perspective, 3% global growth would be stronger than the 2001-2 world recession (which Britain escaped), and stronger than the recessions of the early 1990s, early 1980s and mid-1970s. For advanced economies taken together, however, this will be worse than the early 1990s and similar to the two earlier recessions. The world is being kept afloat by China and India.

In Britain's last big economic crisis, sterling's "Black Wednesday" plunge out of Europe's exchange-rate mechanism (ERM) in 1992, policy activism worked, though it took time for the gloom to lift.

This was when, under Norman Lamont, a new policy was built out of the ashes of the ERM disaster, focused on an inflation target. The policy including aggressive rate cuts led to sustained recovery.

There are big differences. Then we were at the end of a recession, now we are in the early stages. It was a European problem, rather than a global banking crisis. And, while the Bank blew Britain's currency reserves in a vain attempt to prop up the pound, the cost to the taxpayer was small.

All crises end, and this one will be no exception. The IMF predicts a recovery will "progressively take hold" next year but recovery will be "unusually gradual".

The Bank, in taking part in the co-ordinated rate cut, noted everything was weak and appeared to acknowledge recession, pointing out there was no growth in the economy in the April-June quarter and that surveys suggest a further weakening in the second half. This must also be the message from its own regional agents.

Predictions, as I say, are risky, but the "Sarp" looks the right way of ensuring the stability of the banking system if it is put into place quickly. Stabilising the economy, after all the frights of the past month, will take longer. The kind of forecast the IMF has for Britain next year, essentially zero growth, is weak but not disastrous. If the Sarp works, and is bolstered by further bold moves on interest rates, it could be possible to avoid anything worse.

But if the events of the past month have removed any growth from Britain's economy next year, what will the next couple of months bring? Britain has come up with a good plan but remains at the mercy of the markets. They need to stabilise, and fast.

PS If there was ever a prime minister made for the Davos World Economic Forum it was Tony Blair. Some of us have had the privilege of seeing Klaus Schwab, its president, pouring his own Swiss syrup over him and probing him with questions of the "How difficult is it to be so wonderful?" variety. Even Blair blushed.

Gordon Brown is no Davos man, regarding it as something to be done in a day. The two are unrelated but while the Forum was in love with Blair it was also in love with the British economy, regularly giving it a high ranking in its annual World Competitiveness Report.

Now the affair is over. Britain is down from ninth to 12th place, ranking behind America, the Nordic countries, Singapore, Hong Kong, Japan, Switzerland, Germany and the Netherlands.

Business leaders like the flexible job market and still think we have competitive financial markets (though they have slipped from second to fifth in the world). The real dive is on the macroeconomic environment, ranked a lowly 58th, due to "low national savings, a growing public-sector deficit and consequential public indebtedness". Brown needs to do some schmoozing.

From The Sunday Times. October 12 2008